Hangover Part 2: How public pension pain will deepen

April 23, 2013

Updated Aug. 21, 2013 1:17 p.m.

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Last week, the giant California Public Employees Retirement System – which serves the overwhelming majority of local governments – embraced a new resolve to return the system to fully funded status within 30 years.

Last week, the giant California Public Employees Retirement System – which serves the overwhelming majority of local governments – embraced a new resolve to return the system to fully funded status within 30 years.

Second of two parts

We spoke yesterday about how assumptions can make an "ass" out of "u" and "me," and how officials made a lot of bad assumptions when they hiked public pension benefits and quit contributing to pension funds, and how the time to pay the piper is upon us all.

Last week, the giant California Public Employees Retirement System – which serves the overwhelming majority of local governments – embraced a new resolve to return the system to fully funded status within 30 years. This will require billions more every year from local governments, which will mean less money for other stuff. (Chart)

Some perspective: The budget bite of pensions has already more than doubled since 2006, according to a review of local cities by Joe Nation of the Stanford University Institute for Economic Policy Review. As of last year, Costa Mesa paid 11.4 percent of total city spending on pensions; Newport Beach, 7.9 percent; Fullerton, 7.2 percent; and Anaheim, 3.5 percent (smaller partly because Anaheim runs its own power utility, which pumps up overall spending).

Now imagine hiking that by another 35 percent to 50 percent, and leaving it there for decades, and you'll sense the squeeze that agencies are facing.

WHAT DID CALPERS DO?

It's egghead sort of stuff, but it boils down to that assume thing again: It adjusted its optimistic assumptions. The days of gladly paying tomorrow for a hamburger today are on the way out.

•One of the things CalPERS does for its members is called "smoothing" – which spreads big losses (or gains) out over several years so cities and other agencies aren't walloped with wildly varying pension bills from year to year. The smoothing period now changes from a 15-year rolling period to a five-year direct, according to a translation by the League of California Cities.

And the amortization rate – i.e., the length of time required to eliminate a pension plan's unfunded liability – changed from 30-year rolling to 30-year fixed. Our friendly translators at the Texas Attorney General's office explain that a fixed AR means that all obligations will be fully funded by a specific target date in the future, while a rolling AR means that a plan's obligations will never be fully funded, but that a constant AR will be preserved from year to year.

Einstein once confirmed that compound interest is the most powerful force in the universe, Nation quipped; the big hike in contributions in the early years will help ensure that the funds build on themselves and the entire system recovers.

"This was one of the most difficult, yet most important decisions we have had to make," said Rob Feckner, president of the CalPERS Board, in a prepared statement. "Moving our plans more swiftly toward full funding will ensure a sustainable pension system for our members, employers and ultimately taxpayers over the long-term."

The new rates are slated for 2015 for the state and schools, and one year later for cities and special districts. The League of California cities told its members to expect the highest increase the very first year, with slight increases in years seven and 10. "These increased rates will remain at those levels from 2020 on for decades. CalPERS estimates that these increases will result in the unfunded liability being paid down by 2045," the League's analysis said.

That's the good news.

'INCREASES UNMANAGEABLE'?

The bad news is that this could lead to more municipal bankruptcies.

"To maintain balanced budgets and healthy reserves, local governments will have to cut costs elsewhere," said Moody's, the credit-rating agency, in its weekly outlook for public finance. "While there is time to plan for the increase, the most fiscally stressed municipalities could find the increases unmanageable."

It is medicine, however, that California needs to take. While the changes will indeed increase short-term budget pressures on many public agencies, in the long term, they will benefit both the state of California and its local governments, Moody's said.

Nation told Fullerton it's looking at $15 million to $20 million a year in pension payments. But other cities weren't eager to estimate how high their payments will rise once the new CalPERS rules take effect.

"It is premature to comment on specifics," said Anaheim spokeswoman Ruth Ruiz said by email. "However the City has already anticipated such increases and programmed amounts into the five-year financial planning forecast. Further for the majority of employees, the City has in place a cost-sharing arrangement that results in not only the City contributing more as a result of the increase in required contributions but the City employees are also responsible for increased contributions. Taking action to ensure the sustainability of the plan for all participants is a priority."

In Nation's $25,000 review of the pension mess for the city of Fullerton, he calculated shortfalls on a per-capita basis for seven local cities. Under less-rosy-than-official return assumptions (6 percent), it amounted to a high of some $5,000 per resident in Newport Beach, and a low of $2,300 in Fullerton.

Ouch. This prompted Newport Beach City Manager Dave Kiff to do some number-crunching of his own. Kiff looked at the holes through the prism of each city's general fund revenues – arguably, a measure of its capacity to pay, he said. By this measure, Santa Ana had the heaviest load, and Newport Beach the lightest.

"I don't do this to minimize the concern – reducing unfunded liability remains a critical focus of the City Council," Kiff told us by email. "I struggle with the impression left on a Watchdog reader when they see 'Unfunded Pension Liability per person.' It is literally true ... But there is a difference between a formula (UPL/person) and who or what will pay for the unfunded pension obligation.

"To be more specific, some folks read what you and others wrote last time and said, 'so my household pays that off!?!?' No. We pay that using sales taxes, hotel bed taxes, income properties (beach parking revenues, the Balboa Bay Club, more) employee contributions (employees are starting to pay part of the employer rate), property taxes (including from large commercial properties – not just residential), and much more. That's our capacity to pay."

NEXT MOVES

Most agencies have made the simpler changes. They've shrunk the size of the workforce. They've scaled back retirement benefits for new workers. They've cut back on cost-of-living adjustments. They're basing retirement benefits on the last three years' salary, rather than the last single year (which makes spiking harder). They're asking workers to kick in more for pension and health benefits. And they're pursuing efficiencies such as regionalized fire and police services.

But that's not nearly enough, Nation cautioned in his presentation to the Fullerton city council.

"In my opinion, the only way to really address this crisis is to deal with benefit levels for current employees," he told the Fullerton council. "I know that's toxic politically. I know that's really tough to do. But I think that, unless you do that, you'll never get your arms around this problem.

"The way I think of it is, you've got this pie of obligations. Half of the obligations you have are to the people who've already retired. Which leaves you with only half the pie.

"If you've only got half the pie left, and you can only tinker with a very small slice of new hires, you can't really change things. And you have to be able to change things...and I'm not suggesting for a second that you tell a retiree or even someone who has been an employee for 15 years that you're going to take away what they've earned to date. What I think you have to do is say, 'You have accrued a certain amount until today. But going forward it's a different game.' That's the way it works in the private sector."

A legion of critics disagree with Nation. The promises made to employees on the date of hire can't be changed, they argue. Those promises are essentially a contract, and are bound by contract law.

PAYING THE PIPER

In the end, public agencies and their workers will need to embrace benefit reductions, employee cost sharing and – gasp – new revenues to deal with the problem, Nation told Fullerton.

"Political and other constraints greatly complicate any effort to increase revenues (particularly if the revenues are viewed as a 'pension tax')," but the city should consider an increase in its sales tax rate, as well as a supplemental property tax, to pay for pension and health care obligations, he said.

In Fullerton, a half-percent hike would raise about $7 million a year, and a supplemental property tax of $272 per household would raise about $13 million a year.

This remains a very tender topic, and folks in officialdom aren't going there. At least, not yet. "We have absolutely no direction from council to go in that direction," said Fullerton City Manager Joe Felz.

Felz is heartened that Fullerton, at least, is starting from a better point than a lot of other cities. Said Nation: "You've managed to turn this aircraft carrier in the right direction and start moving it in that direction. That's not the case I think across California. There are a lot of cities that are still in a state of denial."

Fullerton – and the other cities that have embraced reforms – have begun a very long climb out of the hole, Nation said. The next 10 years will be tough, but the 10 after that will be relatively easier. "You started in better shape and generally have made more changes and advanced more reforms than the other cities," Nation said. "I would just encourage you to continue down that path as quickly as you can."

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